When Handing Out Subsidies, Government Doesn't Need Middlemen

The housing bubble shows that public-private partnerships don't always go so well

These days, you hear a lot about public-private partnerships. The government likes the idea of the private sector lending a hand to help it attain its goals, and the private sector likes the boost to profits that government initiatives can provide. But such arrangements aren't always win-win situations. During the housing bubble, a key mistake made by government housing policy was trying to increase homeownership by enlisting private support.

This and a variety of other housing finance policy topics were discussed at an event today put together by the Roosevelt Institute. The first panel discussion sought to investigate the government-sponsored enterprises' role in the crisis. A number of interesting points were made, but one of the sharpest came from financial industry analyst and consultant Joshua Rosner. He's also the co-author of the book "Reckless Endangerment," which examines the culture at the GSEs that helped to create the bubble.

A common problem in economics is when a firm captures its regulator. This is a fancy way of saying that its regulator lets it get away with whatever it wants. With Fannie and Freddie, the situation was different in a key way: they captured Congress. That way, even if a regulator tried to crack down on Fannie, Freddie, or one of the firms it worked with, Fannie and Freddie would appeal to its friends in Congress. Lawmakers would then instead chastise the regulator and tell the GSEs and banks to carry on. For this reason, different regulation might not have helped: if Congress renders a regulator impotent, the rules in place will be ignored anyway.

Instead, Rosner suggests a different root of the problem. He notes that the government chose to push its affordable housing mission through private sector firms. This was a flawed strategy. He explains the problem in his response to an assertion that better regulation could have been put in place to compliment the homeownership push:

I won't disagree that that could not have been done. I'm not sure that even if had that been done, the most effective way to deliver subsidies in favor of homeownership is linking homeownership to the structure of mortgage markets, rather than direct subsidies one way or another. And frankly, you would take away a lot of the tolling and rent-seeking behavior, not just of private market players, i.e. the mortgage banks, but all of the groups that seek to be the beneficiaries and deliverers of those subsidies, and that's some of the non-profit organizations. There are effective ways of delivering the subsides in support of homeownership that we did not attempt to engage in.

This is an important point. Think about the process as it was. One of the GSEs funds a loan, which includes a subsidy. Let's say that without that subsidy, a particular borrower could not have afforded a home. This furthers the end of expanding homeownership.

But in order for that to happen, a mortgage broker may have first originated that loan, and charged the borrower a fee. Then that broker sold the mortgage to a bank, which charged a fee. Then, the bank sold that loan to a GSE, which charged a fee (remember, they were quasi-private firms at the time). Maybe the GSE then securitized that loan, effectively selling it to investors, who also charged a fee. Every party that touches this mortgage gets a cut. And consequently, every party that touches this mortgage has an incentive to keep originating more and more loans and possibly behaving badly in the process.

What if, instead, the government just had a program that simplified the process, cut out all those middle men and funded the mortgage directly? After all, if homeownership expansion is its ultimate goal, why not just get from Point A to Point B faster, instead of zigzagging around the mortgage banking industry, handing out money along the way?

A direct subsidy would be more efficient and would be less likely to result in misaligned incentives resulting in a market failure. To the extent that the government maintains a role in expanding homeownership, this is a feature any new strategy should adopt.

Daniel Indiviglio was an associate editor at The Atlantic from 2009 through 2011. He is now the Washington, D.C.-based columnist for Reuters Breakingviews. He is also a 2011 Robert Novak Journalism Fellow through the Phillips Foundation.
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Indiviglio has also written for Forbes. Prior to becoming a
journalist, he spent several years working as an investment banker and a
consultant.